The 20% drop in the Japanese stock market in just three days in August and its subsequent recovery during the rest of the month leave relevant lessons.
– All financial markets are highly interconnected. The fall of one of the world’s major stock markets, such as Japan’s, is reflected almost immediately in the rest of the stock markets, although with varying intensity. This is what happened in August and it will continue to happen in the future.
– Although avoiding sudden falls in stock markets is not part of the mandate of central banks, in practice it is something they take into account. In the case of Japan’s fall in August, the BoJ (Bank of Japan) governor said that there would be no further rate hikes as long as financial markets were unstable. Central banks are not immune to the consequences of a sharp fall in prices. The BoJ made this clear.
– There is still liquidity and global appetite for equities. As the August movements showed, as soon as there is a rapid correction (nearly 10% on the Eurostoxx and the S&P), purchase orders reappear which cause the stock market indices to rebound in a few sessions.
– Danger of leverage in investments. During periods of calm in the financial markets, positions are built, in many cases with leverage. The calmer the markets remain, the greater the volume of leveraged positions. In these leveraged positions, the investor only disburses a portion of the nominal amount of the investment. When volatility and sharp price declines begin, investors are required to provide more collateral (margin call).
The stronger the price movement, the greater the volume of additional guarantees requested. Faced with the difficulty of respecting the new guarantees, many investors are forced to undo their positions by selling them, causing a further drop in prices and creating a vicious circle.
During the August declines, the collateral required for leveraged positions “bought” on Japanese stock indices increased by between 60% and 80%, leading to numerous position closures. In short, in the face of financial market turbulence, leveraged positions built up over a long period of time can hardly be unwound in an orderly manner without causing significant declines. with the additional risk of generating vicious circles: falls-closing positions-more falls-more closing positions…
– Danger of yen carry trade. One of the main causes of the August declines is attributed to the closing of positions on assets financed in yen. The greater the gap between the yen interest rate and the investment currency, the greater the profitability of the investment. In addition, the more the yen weakens against the currency in which the investment is made, the more advantageous it is to repay the loan in a devalued currency.
In addition to the yen-funded positions, one must also consider the $3.4 trillion (billions Americans) of Japanese investment abroad. It is virtually impossible to know how much of this investment is financed in yen.
– The Fed is well aware that cutting interest rates too sharply or too quickly could strengthen the yen and cause a new wave of closings of positions financed in yen. If the interest rate differential between the US dollar and the yen narrows, financing in yen becomes less attractive and, in addition, the yen will tend to appreciate.
He yen carry trade This has been one of the catalysts for the rise in the US stock market, cryptocurrencies and other risk assets. It seems difficult for the Fed to undertake the nine interest rate cuts that the market is pricing in through the end of 2025.
Lots of interesting lessons to start the new course.
